Waiting (And Hoping) For Dr. Bernanke

U.S. stock indexes opened sharply higher yesterday with the Dow Jones Industrial Average (NYSEACA:DIA) gaining more than 100 points in early trade and the S&P 500 (NYSEARCA:SPY) adding 0.93% to trade back above its 50 day moving average.

Credit markets were less exuberant with iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF) dropping 0.28%.
 
In Spain, trouble continues as borrowing costs spiked higher in a 12 and 18 month bond auction.
 
The 12 month bonds jumped to 5.07%, up from last month’s 2.98%, and the 18 month interest rate also climbed sharply.
 
The all important 10 year bond declined slightly to 7.03% but stayed above the “unsustainable” 7% level.
 
Spain will sell more bonds on Thursday as it struggles to gain access to global capital markets.
 
So why do we care about Spain?
 
Spain and what happens to its sovereign debt are key ingredients into what actions the Federal Reserve might or might not take. It’s clear that the debt crisis in Europe is nowhere near under control as bond  yields continue hitting new records and Spanish debt obligations, much less Italy’s, threaten to swamp any firewall that the European Union has so far been able to build.
 
Against this backdrop, Dr. Bernanke and his Fed have to decide how to proceed at their two day meeting that got underway yesterday.
 
Stock markets opened sharply higher as market participants clearly expect Dr. Bernanke to engage in some sort of monetary easing, while bond markets seem less excited about the whole thing, just moving slightly in expectation of tomorrow’s announcement.
 
The Fed has several options as Operation Twist comes to a close in June.
 
The most widely expected is an extension of Operation Twist wherein the Fed continues exchanging short term notes for longer dated securities. Another widely discussed possibility is that the Fed will add mortgage backed securities to the mix to further stimulate the beleaguered housing market which reported another sharp drop in housing starts for May. The final option would be outright new purchases of new bonds, “QE3,” which would be the most aggressive stance.
 
So here we are, with market players waiting and hoping for Dr. Bernanke to once again ride to the rescue of world financial markets. 
 
Widely known as “Helicopter Ben” or “Bazooka Ben,” it’s highly unlikely that Dr. Bernanke will sit on his hands at this month’s meeting. But he’s faced with a couple of problems. First of all, his supply of short term debt that he could exchange for long term debt is shrinking. Secondly, if he pulls the trigger now on QE3, what will he have left if/when Spain and Italy implode and financial markets would need Fed support more than ever?  Finally, each round of quantitative easing has a diminished effect and so many analysts think he needs to keep his powder dry to see if Europe can save itself or not.
 
Bottom line: The most likely announcement today will be an extension of Operation Twist and that the Fed stands ready to act if conditions in Europe or the United States should worsen. A slightly stronger move would be to add mortgage backed securities to the mix. However, no action would be a huge disappointment to market players who clearly anticipate a shot from Dr. Bernanke’s bazooka. More volatility is virtually a given, “buy the rumor, sell the news” is a likely possibility, and Spain and Greece remain on the edge of disaster. It will be an interesting week.
 
Disclosure: Wall Street Sector Selector actively trades a wide range of exchange traded funds and positions can change at any time.